Credit Rating Agencies and Tourist Traps -- Can You Get What You Pay For?

What chance is there that the restrictions on the credit rating agencies, announced by the US Securities and Exchange Commission on December 3 – here --will actually be for the better? There is plenty of reason for doubt.

Although vital players in the credit market implosion that has triggered recession on a global scale – here – the rating agencies are receiving only wrist-taps: a bunch of additional disclosure about their processes and results, plus a vague scolding about the conflicts presented by their advisory involvement in the structure of their clients’ rated financial products.

An exercise for another day will be to compare the limpness of the SEC’s approach with the equally lackluster attitude of the Treasury Department’s Advisory Committee toward the accounting profession – see here. For now, two observations suffice:  

• First, neither the basic business model nor the inherent performance issues of the rating agencies are about to be disturbed.

• Second, it is therefore not cynical to note that Moody’s, S&P and Fitch all support the SEC’s moves -- an indicator of how little effect they will have.

An apt comparison struck me earlier this week. I was loitering in a sidewalk café in the Muristan neighborhood of the old city of Jerusalem, when one of my fellow tourists emerged from Shadi’s souvenir emporium, waxing expansive.

Earlier in the trip, the shops in Bethlehem had offered her a mere discount of 15%. She was enticed that while Shadi was posting his “usual” 25% rebate, as a holiday gesture for the Christmas season, he would go all the way to 50%.

To reinforce his probity and to open her wallet, Shadi backed his eloquent pitch by invoking his government-issued certificate as an approved dealer in antiquities, along with his personal assurance that the silver was all sterling, the coins were all Roman and the stones were the finest local malachite.  

I felt almost grinch-like in suggesting to my friend that certain rules of trade applied to amateur shoppers and one-time visitors:

•    Foreign tourists had no information at all about the store’s underlying costs or concealed profit margins. 

•    Each shop around the square was hawking precisely the same goods as were on offer in all the others.

•    The souvenir sellers were not charities, and most unlikely to do any transaction on a money-losing basis.

•    Buyers had no practical recourse whatever, once they and their purchases left the store and headed back home across the ocean.

As made starkly clear in the catastrophic collapse of exotic financial instruments despite their investment-grade ratings, investors put themselves no less at the mercy of the promises made by the touts of stellar reputations and superior expertise.

Nor is that condition subject to change at the hands of the bureaucrats. Regulation can at best only guide, but cannot promise, scrupulous normative conduct – whether the honesty of a souvenir peddler or the reliability of a rating agency. It’s not the stop sign that saves the lives of pedestrians, after all – it’s the socially-agreed convention that cars will actually stop in front of the red octagon. Or, sometimes not.

A tidal wave of litigation is building that will sweep over all the players in the credit market debacle – a trend admirably tracked and explicated by Kevin LaCroix at the D&O Diary.

It remains to be tested whether the defense of an “unprecedented business crisis,” advanced by the rating agencies along with the other lawsuit targets, will ultimately prevail. And when at the global economies do emerge from the current environment of disaster, only time and the next inevitable cycle of white-collar rapacity will test the SEC’s attempt at the imposition of virtue – noting only that this outcome has never been accomplished in any prior cycle of regulatory reaction.

Either way, even ostensibly sophisticated investors placed undue credulity on the rating agencies and their role.

In serving a function of some utility, not unlike the souvenir sellers in the old city market, the rating agencies operate under well-known conditions, including engagement by their clients and involvement in the deals being rated.

So long as those conditions obtain, changes at the margin -- to make the rating agencies buy their own basketball tickets and re-label the scope of their engagements -- will leave users to their own due diligence, where they should be anyway.

In both cases, a serious degree of caution is indicated, lest the trusting and the naïve be left holding empty bags and empty promises.

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Comments

[auditscaper]

I think your analysis is spot on

[Gary Miller]

Well said- I find your commentaries to be extremely articulate and apparently well grounded in hands on experience. Nice job!